Crescenzi: Fed Exit Best As Process, Not Event

The best way for the Federal Reserve to smoothly exit from its current stance on monetary policy is to make it more a process than an event. This approach has worked thus far, with the Fed having constructed programs that “naturally” shrink when market participants decide that they either no longer need funding or can find it more cheaply from other sources.

For the next stage of the exit process, the Federal Reserve will ultimately have to alter the most important sentence of its recent policy statements:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Market participants understand that if the Fed withdraws its stated commitment it would mark an important event with broad implications for the financial markets, in particular the interest rate markets. For example, an ending to the commitment on rates would likely cause the yield curve to shift, with rates higher across all maturities and in particular the short-end of the yield curve. In turn, risk assets would likely under-perform, raising the cost of money for U.S. corporations, municipalities, and other borrowers, while also spurring wealth destruction.

Escape Velocity Not Achieved

Tighter financial conditions emanating from higher interest rates and a decline in risk assets would impede the handoff necessary between the fiscal and monetary authorities and the private sector. This handoff is not yet in place, as U.S. economic activity has not yet reached a self-reinforcing condition, a cycle of self-reinforcing increases in production, income, and spending. In other words, the rocket ship hasn’t yet achieved escape velocity because the final stage of the rocket booster has not yet ignited; the private sector is still dependent upon the fiscal and monetary authorities to stay in orbit.

Language Tweaks at Most; Conditioning Changes to the Commitment

Hence, the timing is not yet right for a change in monetary policy and it remains some distance away. The Fed will thus want to avoid giving the impression that a policy change is either in the offing or nearer than before. Any language change would therefore be geared toward making policy changes be more a process than an event. The best way to do this is to alter the commitment sentence to be more conditional than it currently is.

In other words, the Fed should indicate more specifically the type of economic and financial conditions that would “warrant exceptionally low levels of the federal funds rate for an extended period.” In doing so, market participants would have greater clarity on what would spur a change in policy, and would react incrementally in process-like fashion to incoming economic data and evolving financial conditions, rather than suddenly to either a Fed policy statement or to signals by Federal Reserve officials during the inter-meeting period. One might say that this is something the markets are already doing but it is not the case; most are unsure of what would provoke a change and the level of policy intervention is so high that it requires more clarity than normal regarding what would spark a change.

By making conditional any changes to its policy commitment, the Fed changes not the timeline of any policy change, lessening or smoothing the market response—a desirable outcome and one that would most likely from making the exit strategy more a process than an event.

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______________________Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."